Quick overview

A captive insurance arrangement is a customized risk-financing tool: the parent company forms a licensed insurance company (domestic, offshore, or a cell within a protected cell company) that underwrites the owner’s risks. Captives can reduce long-term costs, increase coverage flexibility, and improve loss control — but they require governance, capitalization, actuarial rigor, and ongoing regulatory compliance.

This article explains when a captive may make sense, what to evaluate during a feasibility study, practical next steps to set one up, common pitfalls, and how to judge whether a captive is the right part of a broader risk management program.

Disclaimer: This is educational content, not legal, tax, or investment advice. Captives have complex tax and regulatory consequences; consult a qualified tax attorney, actuary, and your state insurance regulator before acting (IRS; NAIC).

Why businesses form captives

Businesses consider captives to achieve one or more of the following goals:

  • Gain control over underwriting, claims handling, and loss-prevention incentives.
  • Achieve more predictable long-term insurance costs when commercial markets are volatile or limited.
  • Capture underwriting profit and investment income that would otherwise go to commercial insurers.
  • Customize coverage for hard-to-place or industry-specific risks (e.g., cyber, product recall, professional liability).
  • Access alternative tax and financing structures where appropriate and compliant.

In my practice I’ve seen mid-sized manufacturers and professional-service groups use captives to stabilize costs and tailor cybersecurity and professional liability coverage that traditional carriers offered only at prohibitive prices.

Sources and further reading: IRS guidance on captive arrangements and small insurer elections, NAIC resources on captive domiciles, and practical articles from industry journals (IRS; NAIC; Journal of Accountancy).

Key indicators that a captive may be worth considering

A captive is not for every company. Strong indicators include:

  1. Predictable frequency (not necessarily severity) of losses. Captives work best when losses are somewhat predictable so premiums and reserves can be modeled.
  2. Material premium spend in the commercial market. If your annual premiums are large and growing, potential savings from retained underwriting profit and lower broker fees can justify the captive’s fixed costs.
  3. Repetitive or specialized exposures that commercial markets exclude, limit, or price poorly (e.g., certain cyber risks, product recall, environmental remediation in defined scenarios).
  4. Management capacity and willingness to accept additional governance obligations, including an independent board, annual actuarial reviews, and compliance reporting.
  5. Time horizon of several years. Captives are a medium- to long-term strategy; transaction and setup costs mean benefits appear over time.

If several of these indicators apply to your business, proceed to a feasibility study.

Feasibility study: what to analyze

A robust feasibility study is the single most important step. Typical elements include:

  • Loss history analysis and actuarial modeling: quantify expected losses, tail risk, and variability.
  • Premium and expense comparison: compare projected captive premiums plus administration to current commercial costs, including brokerage, retentions, and coverage gaps.
  • Capital and liquidity needs: determine initial capitalization, working capital for claims and operations, and reinsurance strategy.
  • Tax and accounting review: analyze federal and state tax treatment, possible elections (for small captives see IRC 831(b) guidance), and GAAP/Stat accounting impacts.
  • Legal and regulatory assessment: domicile options (onshore states vs. established offshore jurisdictions), licensing requirements, minimum capital, and reporting obligations.
  • Governance and operations plan: proposed board structure, captive manager role, claims administration, and outsourced services.

Note: tax items such as the IRC 831(b) election and premium thresholds change over time and receive IRS scrutiny; always confirm current IRS guidance before relying on tax savings (IRS). Avoid promising tax outcomes to stakeholders without written tax advice.

Structure choices and domicile

Captives come in several flavors: single-parent (pure) captives, group captives, sponsored captives, protected cell companies (PCC), and risk retention groups (RRGs) for liability. You’ll also choose a domicile. Popular onshore domiciles include states with captive-friendly rules (e.g., Vermont, Delaware, and others), and offshore domiciles include Bermuda, Cayman, and Guernsey.

Domicile choice affects minimum capital, corporate governance, reporting, and perceived credibility with reinsurers and banks. Regulators at both the state and federal level (and sometimes foreign regulators for offshore captives) will expect capital, audits, and ongoing filings.

Common benefits and trade-offs

Benefits

  • Custom coverage tailored to your exposures.
  • Potential cost savings over time and access to reinsurance markets.
  • Improved risk management incentives and claims transparency.

Trade-offs

  • Setup and fixed administrative costs (captive manager, actuary, legal, auditors).
  • Ongoing compliance and governance obligations.
  • Capital tied up to support reserves.
  • Tax and transfer-pricing scrutiny if arrangements aren’t arm’s-length.

Practical steps to set up a captive (high-level)

  1. Assemble a project team: CFO, insurance leader, external captive manager, actuarial consultant, tax counsel, and captive-friendly insurer/ reinsurer.
  2. Run a feasibility study and board-level business case.
  3. Select domicile and legal entity form; prepare licensing application (state regulator or offshore authority).
  4. Capitalize and establish banking, investment, and claims administration arrangements.
  5. Purchase reinsurance as needed; implement reporting and internal controls.
  6. Begin operations with quarterly monitoring and annual actuarial and audit reviews.

In many cases, especially for smaller firms, joining a group captive or sponsored program reduces entry cost and regulatory burden while preserving many benefits. See our deeper discussion of captives for small businesses: Captive Insurance for Small Businesses: Pros and Cons.

Tax and regulatory cautions

  • Tax treatment can be complex. The IRS examines whether an arrangement is a bona fide insurance company or a tax avoidance device. The presence of real insurance risk transfer, commercial reinsurance, and economic substance are important (IRS guidance).
  • Small-captive elections under Internal Revenue Code Section 831(b) and similar provisions have historically offered benefits but attract increased scrutiny and have specific premium limits; verify current thresholds and guidance before proceeding.
  • Transfer pricing and intercompany agreements must be documented and operate at arm’s-length.

Operational and governance best practices

  • Maintain independent board members or advisors with insurance expertise.
  • Use periodic actuarial reserve reviews and an annual audit.
  • Document underwriting standards, claim reserve policies, and reinsurance purchasing policies.
  • Implement strong loss-control programs and tie management incentives to loss reduction.

Red flags and common mistakes

  • Forming a captive primarily for short-term tax gains without a real insurance business plan.
  • Under-capitalizing the captive or ignoring reinsurance for catastrophic layers.
  • Failing to document arm’s-length pricing, intercompany agreements, and governance processes.

When a captive is not the right choice

  • You have highly unpredictable, low-frequency, high-severity exposures that a captive cannot support without large capital concentrations.
  • Your premium spend is too small to offset setup and operating costs.
  • Management lacks time or willingness to run an insurance entity and to meet regulatory demands.

Examples (illustrative)

  • A regional manufacturer with predictable product-liability claims created a single-parent captive to write primary layers and buy reinsurance for catastrophic risk; savings and improved loss-control incentives reduced their combined ratio over five years.
  • A group of dental practices formed a group captive to pool risk and create affordable dental-malpractice coverage; the program improved pricing stability and loss-prevention coordination across members.

Additional resources and related topics on FinHelp

Final checklist before deciding

  • Complete an independent feasibility study with actuarial support.
  • Obtain written tax and legal opinions on structure and domiciliary requirements.
  • Confirm initial capitalization plan and reinsurance arrangements.
  • Establish governance, audits, and ongoing reporting processes.
  • Model multiple years of cash flow under stressed-loss scenarios.

If you reach this point and the numbers, governance plan, and risk profile align, a captive insurance arrangement can be a powerful strategic tool. However, because captives blur insurance, tax, and corporate law lines, work with experienced advisers and your insurance regulator to ensure the arrangement is credible, compliant, and sustainable.

Authoritative sources cited in this article: Internal Revenue Service (guidance on captive insurance and small-captive elections), National Association of Insurance Commissioners (domicile and regulatory information), and industry commentary (Journal of Accountancy; Investopedia).